YOU DECIDE: Is economics sabotaging alternative fuels?

February 09, 2007

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In his State of the Union address, President Bush called for an increased use of alternative fuels by American drivers.

But entrepreneurs haven't waited for this mandate. Across the U.S., including North Carolina, alternative fuel factories spring up almost daily.

The country is riding a wave of optimism about new energy sources like ethanol and biomass fuels. These alternatives are popular, in part, because they're based on renewable domestic sources. For example, in the case of corn-based ethanol, a large amount of corn is grown in our country, and the crop can be replanted each year. Many people have visions of homegrown corn stalks replacing imported foreign oil.

Yet just when it looks like the momentum is in favor of alternative fuels, economics - also known as the "dismal science" - rears its head. Changes in two key prices have raised questions about the viability of ethanol and other new fuels.

One change is in the price of oil itself. Today, oil prices are well below their highs of last summer, due in part to the calm 2006 hurricane season and until recently, the relatively mild winter. Although experts disagree on where oil prices are headed, one fact is clear. The lower oil prices are, the more gas prices fall, and the less motivation drivers have to switch to gas alternatives.

The second change occurred in the price of the major input to the primary gasoline alternative: ethanol. This input is corn, and corn prices have almost doubled in the last 15 months. Higher corn prices reduce the profitability of ethanol and threaten its long-run financial viability.

Why have corn prices risen so much? Is it part of some plot to sabotage ethanol and tie us even more to imported oil?

The answer is more direct and much less sinister.

Any time there's a large and sustained increase in the desired use of some product, the product's price rises, serving two useful purposes. It ensures the limited supply of the product will go to those who place the most value on it. Also, the higher price will motivate producers to eventually increase its supply, which will cause some decline in the price.

In the case of corn, its higher price has paralleled the heightened popularity of ethanol. Not only has this increased cost added to the expenses of ethanol producers, but it will also impact food prices. Users of food products made directly from corn, like tortillas, as well as food products using corn as an input, such as meat, will also feel the pinch of higher prices.

So is this the hand that economics deals us: the availability of more fuel alternatives in exchange for less-affordable food? Can't our economic system give us both?

In the short term, the answer is closer to "no."

Higher corn prices are likely here for a while as long as ethanol demand remains high. But over the longer term, our economy will adapt. More land will be put into corn production, and as the supply expands, the price will fall. However, this means less land will be available for other uses, such as the production of other crops or livestock or simply unused open space. After all, economics is fundamentally about tradeoffs.

The lesson here is that prices serve as signals. In our economic system, no central authority or economic czar dictates what and how much is to be produced. These decisions are made by millions of individual managers and companies. Higher prices are the signal to produce more; lower prices say move on to something else.

Which brings us back to where we started: the price of oil.

The movement of oil prices from $10 a barrel a decade ago to more than $70 a barrel last summer has been at the base of the charge to fuel alternatives. Now oil prices are well below their all-time high. If they go lower, will drivers still be interested in ethanol and other fuels?

Or will additional ethanol subsidies or gas taxes be needed to keep the country moving toward energy independence? You decide.

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Dr. Mike Walden is a William Neal Reynolds Professor and extension economist in the Department of Agricultural and Resource Economics of N.C. State University's College of Agriculture and Life Sciences. He teaches and writes on personal finance, economic outlook and public policy. The Department of Communication Services provides his You Decide column every two weeks. Earlier You Decide columns are at http://www.cals.ncsu.edu/agcomm/writing/walden/decide.htm